7/01/2012

Intrinsic Value ... Why Bother

Calculating intrinsic value is great if it was dependable and
possible to calculate accurately. The 1938 thesis by John Burr Williams,
"The Theory of Investment Value," was groundbreaking and introduced
us to fundamental analysis. He proposed calculating intrinsic value of a stock
by discounting all future cash flows to the present. No argument, as investors
we know this.

But chances are we don't come close to the true present value
as the future is speculative. Change any of the inputs and we get widely
different present value calculations. The timing of future cash flows, growth
rates, discount rates, future shares outstanding or future debt, terminal value
and ultimately the market's interpretation of its risk and fair value.

So what can we do? Give up? No. We can try to reduce the
portion of our investment thesis that's based on forecasting or speculating.
Lets attempt to increase our odds of determining fair value at least in the
short term. We could try a few approaches. But for this article I'm going to
lean on the teachings of Ben Graham. We all know this is not the only approach
to reach for alpha.

Having said that we will start with the balance sheet. This
starting point to determine fair value is easier in comparison to forecasting
future cash flow, discount rates, growth rates and the other inputs: cash,
receivables, inventory, prepaid expenses, property plant and equipment,
long-term investments.

So if we can come up with a reasonable fair value of these
assets and compare it to our liabilities we may be a step closer. Once we make
adjustments like the fair value of real estate, equipment or inventory, and
then include our liabilities, we have a number. That number is kind of like
book value but adjusted up or down for fair market value of real estate and the
certainty of items like cash or net receivables. Once we have a value we will
compare that value against the market's value for the stock.

The difference between step one of our more certain estimate
versus the market must be reconciled and challenged. Can this variance be
justified by our intrinsic value estimates of future cash flows discounted to
the present? So the market is assigning a premium or discount versus our
step-one calculations using the balance sheet. Hopefully, this will help us to
uncover over-looked value with more certainty and make the discounting future
cash flow a more reasonable and useful portion of the valuation process.

Joel Greenblatt made the point to his students that if you can
find a company that is undervalued, in time the market will recognize and
adjust. Two examples of Ben Graham-like stocks that reported additional insider
buying (06/18/12) and are sitting on assets that could prove the markets value
as temporary insanity:

The LGL Group (LGL) was founded in 1917. LGL manufactures
electronic components.

The per-share current book value is $9.65. But within that
$9.65 book value per share is cash of $5.15, net PPE of 1.79, inventory of
2.24, and AR of 1.83. Furthermore, current assets less current liabilities is
$6.62 per share. current price is $6.52.

Real estate owned: One building in Orlando Florida along with
7 acres of land. Two buildings in Yankton, South Dakota, located on 11 acres of
land.

Market Cap: $17.93M

Enterprise Value: $7.82M

Historical low valuations based on EV/Sales at .33 and EV/Book
at .45. coupled with strong insider buying.

At this time the market is placing a low valuation on the
business. Yahoo says it has a current enterprise value of $16.93 million; if
you add current liabilities it's closer to $37 million. So the market is giving
us TTM sales of $82 million and $42 million in gross profit for a $16 million
enterprise value or $37 million including current liabilities.

The current market price is $7.87 per share versus per-share
value of current assets less current liabilities of $9.35. EV to book and sales
are trading at historical lows. Current dividend yield is 8.20%.

2 comments:

Anonymous
said...

I'm glad you posted this article for everyone who missed it on Gurufocus. The Joel Greenblatt point about finding a company that is undervalued and the market will eventually adjust is something my father always said. Great post. Teresa

There are certain criteria that make a company easier to value. Companies that grow in a stable and steady manner over time and operate in permanent industries also are easier to value.

The closer the price is to the asset value, the harder it is to argue with the valuation. I think that is an important point: the value should be hard to argue with. The closer the price is to the assets, the less reliant you are on future business events to make up the value -- it is less speculative as Graham says. It's sort of similar to buying an asset-backed bond, which is less reliant on the cash-flow generating capability of the business.

If you are buying a company on a value basis that is selling significantly higher than book value, you really should have an intense understanding of the business and the industry, and, as a simple test of understanding, be capable of presenting evidence convincing enough to persuade an objective, detached, and critical group of people.